Do Economic Conditions Drive DIP Lending?: Evidence from the Financial Crisis

A firm that seeks refuge in Chapter 11 typically requires financing for its continuing operations in bankruptcy. Because such financing is often hard to find, the Bankruptcy Code authorizes debtors to offer sweeteners to debtor-in-possession (DIP) lenders. These inducements can be highly effective in attracting financing. But because these sweeteners are thought to come at the expense of other stakeholders, the Code requires a showing that no less generous a package would have been sufficient to obtain the loan. Anecdotal evidence suggests that the use of certain controversial inducements skyrocketed during the Financial Crisis, leading critics to question whether DIP lenders were abusing their power. Defenders of DIP lenders, however, have responded that the contract terms in DIP loans simply reflect economic conditions: When credit is tight, as it was in recent years because of the Financial Crisis, of course more sweeteners are needed to induce lending.In this Article, we examine the relationship between economic conditions and the terms of DIP loans. Using a hand-collected dataset reflecting contractual detail in DIP loans, we study changes in DIP loan terms during the Crisis. As one might expect, we find that ordinary loan provisions like pricing and reporting covenants are sensitive to economic conditions. But we also find that so-called "extraordinary provisions," often justified as necessary to induce DIP lending, have no statistically meaningful relationship with economic conditions. Our findings have important implications for bankruptcy judges struggling to evaluate whether the sweeteners extracted by DIP lenders are really necessary to induce lending.